Is Oil's Plunge Fueling Techs?

The sharp drop in crude has coincided with the Nasdaq's breakout to a new recovery high

The stock market came to life last week, led by the Nasdaq's breakout to a new recovery high. We believe the impetus for the rally was the continued plunge in crude oil prices. Treasury bond yields rose to their highest level since October.

There are many sectors and industries that will directly benefit from a decline in crude oil prices on a fundamental basis. The one that comes to mind immediately is the airline stocks. The AMEX Airline index (XAL) is up about 45% since mid-August, which was about the time that crude oil peaked. Since Dec. 22, which corresponds to crude's latest peak near $64 per barrel, the XAL has spurted about 13%.

Another obvious beneficiary of falling oil prices is the consumer discretionary stocks. With more money in the pocket, consumers are essentially getting a tax cut from the drop in oil. Since July, the S&P Consumer Discretionary index (XLY) has jumped about 25%, and just last week, the index moved to another all-time high.

We think another area of the stock market that has gotten a nice pop from declining oil prices is technology stocks. The connection here, from a fundamental perspective, is less clear, in our view. We think it has more to do with institutional rotation than anything else. Institutions allocate a certain percentage of their assets to high beta stocks, so that when they sell energy, they replace it with technology. During the energy boom, we think a lot of investors replaced their technology holdings with energy stocks. The S&P IT Services index (XLK) has surged about 28% since bottoming out in July, and the strength in technology stocks has propelled the Nasdaq to new recovery highs.

During crude oil's initial collapse from August until November, 2006, the Nasdaq outperformed the S&P 500. As oil stabilized, the S&P 500 led. However, since the end of December, which corresponds to the latest plunge in oil, the Nasdaq has once again taken over a leadership role. On Thursday, Jan. 11, the Nasdaq busted out of a tight, two-month base on heavy volume, and is now trading at its highest level since February 2001.

While we believe the short-term chart pattern looks bullish for the Nasdaq, a look at longer-term charts, price momentum, internal data, and sentiment are not set-up for a huge move to the upside from here.

The first hurdle for the Nasdaq comes from a trendline that has acted as a ceiling for the index over the last two years. This trendline is part of a bullish channel and sits right above current prices at 2492. Because the recent base was so tight, a measured move based on the width of that base only equates to a move to 2530.78, not far above the Jan. 12 price.

If the Nasdaq can overcome some of our concerns listed above, and we will remind ourselves that price action is the final arbiter, another potential target is based on a Fibonacci extension with respect to the latest correction from April to July. That correction was 350.49 points and if we multiply that by 0.618, and add the product to the high in April, 2006, we get a potential target of 2587.50. Looking at a long-term chart, the next piece of Fibonacci resistance would be a 38.2% retracement of the 2000 - 2002 bear market. This would equate to a move to the 2617 level.

We were expecting a market pullback or correction during the first two to four months of 2007, and while it still may occur, the plunge in oil prices may have delayed what we thought was inevitable. The latest pause in the market was very shallow and well contained, with no price breakdowns or important moving averages taken out. The Nasdaq pulled right back to its 50-day exponential moving average before bouncing to a new high. During intermediate-term advances, pullbacks that are contained by the 50-day average are many times fairly common, and represent bullish action, in our opinion.

During the Nasdaq's two-month pause, daily momentum indicators pulled back from extremely overbought conditions. This, we believe, gives the index a little more breathing room on the upside. The 14-day relative strength index (RSI) fell from a recent high of 76 down to 43, and currently sits at 65. The daily moving average convergence/divergence (MACD) fell back to almost zero, and has since rebounded back above its signal line. However, weekly momentum indicators remain close to overbought levels, and we think this limits the upside.

The S&P 500 broke to a new recovery high on Jan. 12, poking its head just above the 1430 zone. During the recent pause, the index found support just above the 1400 level. This is just above what we consider to be an important zone of support that lies between 1380 and 1400. The S&P 500 pulled back to multiple pieces of support, including two trendlines and the 30-day exponential moving average. The most important, or longer trendline extends back to the lows in August, while the other trendline is off the lows in early and late November. Immediate upside resistance comes from the 21-day price envelope up at 1447. The top of the price channel that has mostly contained prices since August lies up near 1470.

Market sentiment remains fairly optimistic, and is another reason we do not think the market can explode higher from here. CBOE put/call ratios, whether you look at the 5-day, 10-day, or 30-day average, are all putting in lower highs. These ratios have fallen close to levels that have preceded market pullbacks over the past couple of years. However, we think the trend in these p/c ratios will have to reverse to the upside before the market indexes correct. At the same time, market polls have recently shown very high levels of bullish sentiment, something we often do not see prior to upside explosions. The Consensus poll recently hit 75% bulls; the MarketVane poll reached 73% bulls, while Investor's Intelligence was just up near 60% bulls and only 20% bears.

The entire energy patch had a difficult week as the stocks got hammered in light of the almost 6% plunge in crude oil prices. Crude broke important chart support in the $55 per barrel area and appears headed for additional losses. The low close for the week occurred on Thursday at $51.88, and was the lowest finish for oil prices since May 27, 2005. At the Jan. 11 closing low, the bear market in oil equaled almost 33% off the July, 2005 high.

Long-term trendline support comes in at the $46 level. A 50% retracement of the entire move since 2001 targets $47.50. The last major closing low from back in May sits at $46.80. Daily and weekly momentum indicators are all oversold, heading lower, and it is too early for any positive divergences or potential chart pattern reversals to emerge.

We believe crude could fall as far as the $45-$47.50 zone before the next meaningful, intermediate-term bottom is in. One potential bright spot as we look out over the next month or so is that the commercial hedgers, listed in the Commitment of Traders Report, are net long once again after being mostly short over the last two months. There net long position is not large, but it is a step in the right direction as far as oil prices go, in our view.

The 10-year Treasury yield rose to its highest level since October, finishing the week at 4.77%. While oil prices have been going in the right direction for stocks, bond yields are heading in the wrong direction. Since the beginning of December, 10-year yields have climbed about 34 basis points. If our chart reading is correct, the 10-year completed an inverse head-and-shoulders pattern this week, which projects up to a minimum target just above the 5% level.

Before the market gets to 5%, however, chart support near 4.8% must be taken out. In addition, a 50% retracement of the yield decline from June until December also comes in around 4.8%. It is our view that once the 4.8% level is breached, yields are heading to the 5% to 5.25% zone.

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